When President Obama signed the Jumpstart Our Business Startups (JOBS) Act on April 5th, the era of crowdfunding began as individual investors everywhere were promised an opportunity to gain access to venture investments previously limited to institutions, funds, and so-called qualified investors. Come January 1, 2013, we’re told, anyone can be a venture capitalist, but hardly any of these new VCs will know what they are doing. Spurred by the new law we will shortly see a surge of crowdfunding startups giving for the first time unqualified investors access to venture capital markets. And it will be a quagmire.

Like disk drive startups in the 1980s each of these new crowdfunds will project 15 percent market share. Ninety-five percent of these funds will fail from over-crowding, under-funding, mismanagement, lack of deal flow, being too late, being too early, or just plain bad luck. A few will succeed and a couple will succeed magnificently, hopefully raising all boats. The point of this column and the two to follow is to better understand this phenomenon and how readers can benefit from it or at least avoid losing their shirts.

Most people think of KickStarter as the archetypal crowdfund and it is one, but KickStarter is not a way to invest in companies. It’s a way to contribute to or pre-order from entrepreneurs with interesting ideas, but not a way to buy stock in those companies because that would violate the Securities Exchange Act of 1934.

But the JOBS Act will loosen some of those Depression-era requirements, allowing small companies more freedom in how they sell their shares and allowing small investors for the first time to actually buy those shares. In general I think this is a good thing. But the devil is in the details and frankly there are no details yet about the crowdfunds made possible by the JOBS Act, because the regulations have yet to be written. In fact the regulating agency hasn’t even been selected. Still, on January 1, 2013 these funds are supposed to be open for business.

The next six months are going to be very busy in Washington, DC.

Though this is not news to most readers of this column, it’s important to understand that startups are not just important to America, they are vital to our very survival.

Small companies create most of the new jobs in America. Companies less than five years old generate two-thirds of the new jobs created in the U.S. each year. Without these startups more jobs would be lost than created, the U.S. economy would permanently shrink and America would eventually lose its superpower status.

The startups that most reliably become giant American corporations and creators of wealth are technology startups. Technology startups assume types and amounts of risk that are not usually tolerated by large companies. Without startups to compete with or acquire, big technology companies would do almost nothing new. In the United States large companies depend on startups to explore new technologies and new markets.

Startups play a particularly important role in growing jobs out of a recession. New companies produced all of the net new jobs in the U.S. from 2001-2007, and also from 1980-1983, the last big American downturn prior to The Great Recession. Technology startups are leading us out of our current economic mess, too.

The U.S. technology sector is particularly dependent on startups, which are born and die at astounding rates. Ninety-five percent of technology startups fail — ninety-five percent. With odds at 19-to-1 against success, why do entrepreneurs even bother to build these companies? Because the potential rewards are huge (Microsoft and Apple, Cisco and Intel, Amazon and Google were all startups, remember) and for real entrepreneurs there are some things even worse than failure, like boredom or just being like everyone else.

American technology startups change the world all the time and are this countryʼs primary non-military global advantage, though hardly anyone knows that. Encouraging technology startups is the key to keeping America competitive and prosperous, though hardly anyone does that. Technology startups succeed despite these adversities because Americans are full of ideas, startups are so darned fun to do, and they donʼt have to cost that much, either — sometimes nothing at all.

Technology export sales drive the U.S. economy and technology startups drive U.S. industry, yet in this era of too-big-to-die companies hardly anyone knows about or understands this phenomenon.

This is great, but why do we need crowdfunds? Do some research and you’ll learn that traditional venture funds are awash with cash and some are even giving money back to their investors. It would be great if this were a sign of success but it is actually a symptom of failure. Venture returns have been poor for many years for a variety of technical reasons. Some blame it on a lack of good IPOs (compounded most recently by the Facebook debacle) and on The Great Recession, but I think there’s a simpler reason: the venture capital industry has become inbred.

While all roads may have led to Rome, the city-state was very different from the lands that supported it, just as Sand Hill Road is different from Denver or Detroit. Rome was a center of consumption, it couldn’t produce enough food to feed itself, yet it was also the center of power — a power that became distorted over time as the ruling class grew distant from the realities of their minions. For Rome this meant Nero and Caligula and for Sand Hill Road it means second and third generation VCs who themselves may have never built or run a company. It means funds packed with too much money attracting entrepreneurs whose ideas aren’t so much to change the world or build their dream machine as to get funded and exit in three years.

It’s a reality distortion field that has contributed to the poor results Sand Hill Road has seen in recent years.

The glory years of venture investing are over, or threaten to be, unless new blood, new values, and new ideas make their way in. That’s the value of crowdfunding, which promises to bring vast amounts of new capital to bear, not just on the same old ideas but on a broad array of ideas and business types that could never get through a door right now on Sand Hill Road.

33 Comments

it’ll be regulated to the nth degree negating the speed which would be required to succeed, although it may spur traditional VC’s to taker a few more risks.

Stewart McKenna
June 6, 2012 at 2:59 am

Sounds like the Darien Expedition which sucked up the saving of every Scot
in the 1700 and ultimately led to ‘fiscal and political union’ with England in 1707..

David
June 6, 2012 at 5:22 am

Do you think the massive infusion of funds in recent years as had a deleterious effect on true innovation? It seems that with private equity stepping into the game as well and people as you say who have never started a company running vc’s that we aren’t moving foward. The two brothers in Germany that are ripping off every new start up come to mind, people are going more for the sure thing or something more low cost than swinging for the fence.

I would love to see less internet start ups and more new copanies focused on doing bigger things. Like Elon Musks current gigs.

NoTalentHack
June 6, 2012 at 6:33 am

Regulation will initially be more like to the 2nd or 3rd degree until lots of people lose their life savings, the media starts reporting it, state and federal investigations are launched, etc. Then you’ll see the nth degree.

Ryan
June 6, 2012 at 8:24 am

The current set of regulations has almost no real accounting requirements, and as Bob said, no regulatory agency at all.

Therefore if you thought the current crop of banksters, Private Equity vampires, and ethically numb corporate executives were making a mess of previously good companies that produced interesting, desirable and useful goods and services, the next wave of out-and-out con men will really excite you.

A lot of corporate executives in Silicon Valley are borderline psychopaths who keep it in check because of the societal and regulatory pressure on behavior in order to keep their jobs running the company. This new paradigm will give similar psychopaths the access to cash without any pressure at all to perform or behave within societal or ethical norms.

John
June 6, 2012 at 9:51 am

You’d think the government had learned its lesson after the housing collapse, the underwater mortgage problem, a near banking collapse, and a near repeat of the Great Depression. The Glass-Steagall Act (1932-33) was enacted to require banks to operate safely. Most of it was repealed in 1999. We saw what happened 9 years later.

The Securities Act (1933) was enacted to make investments more honest. I have not studied the JOBS Act. If it does not include the proper safeguards, it could take us back to the 1920’s when people invested in junk and didn’t know it.

TemporalBeing
June 6, 2012 at 10:21 am

And yet, VCs and Angel Investors are not behind the most successful of America’s Start-ups.

Most successful start-ups get funded by family and friends – people that believe in the person doing the startup, and often willing to lend a hand to help make it happen. Sometimes they give some money; sometimes help out in the office. And more often then not, they stay out of the way of making decisions except for offering advice when asked or needed. These companies become the basis of local economies, and are often far cheaper to start-up, with better returns than what VCs and Angel Investors get, and it’s all done without running afoul of Security laws.

I’m working on one right now – thus far, I’ve invested nearly $2k, and expect to invest no more than a total of $5k by year end, and less next year. Yes, it’s part-time work; but the ultimate reward will be much greater and well worth it; and I’ll do it without VCs, Angels, or Crowd-sourcing; though KickStarter does have an appeal if I needed to do some pre-sales on something to raise money for R&D.

The show Shark Tank shows some of the problems for VCs – they’re too interested in having a controlling interest; they don’t necessarily bring much help to the table; and they often skip over ideas that have true value but are not on a large enough scale for them. VCs in general also tend to push out the people that are successfully running the company in favor of someone with an MBA and all the right credentials; but often those credentials will hinder them from running a start-up successfully.

As to the new Crowdsourcing capabilities, it’ll probably become another option provided by KickStarter – instead of selling product, selling sharing. So expect KickStarter to adopt it in a very similar manner to how they already to what they do.

nick
June 7, 2012 at 5:46 pm

Where is your data on that? I am not disagreeing, but your statement sounds needs some hard facts to back up. I am going to guess the relative startup success ration 90:10 applies equally to family vs. funded businesses.

As for knowing which innovations will succeed, that is a tough nut to crack. Until something actually exists, how can you know it is needed? Until someone actually succeeds at building a startup into a viable company, how can you tell he or she has the drive and vision to do it?

Certainly the potential is there to tap into funds that normally go out via Angel investing. The question is if there is more than that and if so, how much more?

My idea to ride the crowd-funding wave is to make an E-investment engine, repackage an E-commerce engine for the purchase of shares in your business. Next start selling the E-investment engine to small businesses that want to raise money by selling shares. Also sell-your-own-dog-food and use it yourself.

Eventually there’ll be a plugin for WordPress on buying shares in the blog you’re reading.

Brandon
June 6, 2012 at 1:54 pm

Without knowing much about the croudfunding phenomenon, your description sounds like the venture-capital industry will now have the equivalent of day-traders. If that’s the case I see this bringing much volatility, and frankly little benefit. Again, I don’t know much about this, so maybe I’m off base.

No. Crowdfunding is not creating a marketplace to trade stocks in pre-IPO companies. The base framework which was part of the JOBS bill is online portals can be setup to offer investments to the general public in small businesses/startups.

A company can raise up to $1m/year through crowd funding.

There are caps to how much a person can invest. Income under $100k can invest $2000 or up to 5% of their income whichever is greater. Over $100k can invest up to 10%.

John Everyone
June 6, 2012 at 9:01 pm

All the vampire/ vulture capital has moved into patent trolling, killing the incentive for anyone to do or fund a startup.

Wait for any of the 5% to show promise, then sue / suck the life and profit out of it.

Lack of real patent reform will lead the US to ruin, as innovators flee the troll bloodbath, taking startups overseas.

Anyone see this trend already?

JJones
June 6, 2012 at 11:20 pm

I agree.. that’s why they need new blood.

So we’re all told to be prepared to be sued:
You lawyer up, get patents and then when you fail your lawyers use your patents in the only way now available to them and suddenly you’ve become a blood sucking patent troll.

“Ninety-five percent of these funds will fail from over-crowding, under-funding, mismanagement, lack of deal flow, being too late, being too early, or just plain bad luck.”

Can you hear the screaming, Clarise? The screaming of the lambs?

(Misquoted for effect)

BozoTheClown
June 7, 2012 at 12:05 am

Many many years ago I was a lab tech in a “chemical products” company.

They had a great research system.

I worked on what was the 5th attempt to produce a cost effective version of a recognized “important ingredient.” As preview we reviewed the lab notebooks of the previous attempts that reached back 20 years!

What was the expected … and realized … “success rate,” i.e. projects that produced a final product that was scaled up and marketed successfully?

About 1 in 20.

Thinking back, I realize that it was possible only because of how the company continually recruited, coached, refined and promoted talented people. That’s what still stands out in my mind after all these years (in comparison other places of employment).

Now I realize that some one had to choose the project ideas, budget it, risk the reinvested “profits.” The people in the management chain mainly had started as bench chemists..

Of course at that point, they were less than 30 years beyond the two founding bench chemists.

Who is going to know the most about gaming the new crowdsourcing system ?
Who is going to be motivated to start more than 10 crowdsourcing projects ?
Who is going to devote more of their resources to badgering people to get money than in anything legitimate….?

Scam artists, obviously, are going to do to this, what they did to Obama’s initiatives in funding higher education. Honestly, it makes you wonder if being a sociopathic robot like Romney might be a good thing in a president……(ok…. the part where Romney turns into liquid metal and moves to the center right has made me think twice about that….)

Big but common disconnect: “small company” “startup”. Many of us prefer not to grow to Google size. My tech firm is eighteen years old and employs eight people; we’re looking forward to the next eighteen years.

Most politicians & pundits speak of promoting small businesses, yet the JOBS act seems to target startups. I wouldn’t have minded a tax cut for my existing small business.

I think there are some word choices that are confusing in this article. First the repeated use of “fund”. Crowdfunding is not about setting up a bunch of mini-VC funds. The law allows the creation of portals where companies can offer shares of the company to the general public. Crowdfunding is direct investing in companies. As an investor you pledge funds to a company and if enough people pledge the deal happens and you get shares of the company.

There is no doubt about who is going to be the government regulator of crowdfunding. It’s the SEC. The article you link to is discussing the formation of a self regulatory agency. Stockbrokers have FINRA, Commodity brokers have the National Futures Association. The self regulatory agencies handle things like licensing, testing and compliance; basically the day to day operating rules.
To oversimplify the relationship between the government and the SRA works. If you break FINRA’s rules you have been a bad boy and get a slap on the wrist or possibly thrown out of the business. Break the SEC’s rules and you are doing a perp walk on CNBC.

Crowdfunding might actually be the savior of the traditional VC business. The challenge to big VC’s is the low startup costs make the investments not worth going after. A traditional VC with $100m to invest making 100 $100k angel investments is death by 1000 paper cuts. Crowdfunding is not about making a bunch of mom & pop VC. They are really coming in as angel investors. Lets say to make up some fictional numbers that crowdfunding increases the number of companies that get initial funding by 10x. Even with the increased crap factor this should increase by 5x the number of companies that grow to reach a size where a traditional VC investment makes sense.

I believe the facts written within your write-up is really superb. I’ve been doing work on a preliminary analysis mission regarding this topic and your weblog really helped with numerous considerations that I had. I’m creating a term paper for school and I?m currently following many blogs for assessment.